New IEA research asks: How deep a hole are we in?
Emily Carver writes for CapX
– The Covid-19 pandemic – and the government’s responses to it – have led to a surge in public borrowing and debt;
– The increase in public borrowing does not have to be repaid: provided the government can continue to make the interest payments, debt can simply be rolled over;
– Yes, there are limits to how much debt can be serviced with comfort, but the UK is still a long way off these limits;
– UK public debt has been much higher in the past as a share of GDP, and is still lower now than in many other countries, including the US, France, Italy, and Japan;
– The Office for Budget Responsibility’s latest forecast mapped out three scenarios. Due to recent more positive economic data and the vaccine rollout, the OBR’s “upside” scenario, which would see public debt drop to 90.5 per cent of GDP in five years’ time, now looks closer to the mark than the “central” one (in which we permanently lose nearly a year and a half’s growth potential);
– This would mean a faster recovery, and no significant long-term damage to the economy or public finances;
– Even so, it is important to stress that high public spending and borrowing has costs, including the misallocation of resources and the risk of runaway inflation.
In a new briefing paper for the Institute of Economic Affairs, economist Julian Jessop explains how some of the concerns about the public finances are wrong – or at least exaggerated. The good news, he writes, is that the increase in borrowing to pay for Covid does not itself have to be repaid. Provided the government can continue to make the interest payments, debt can simply be rolled over.
Indeed, this is usually what happens: the last time that the UK government ran an annual budget surplus was in 2000-01. Public sector net debt had already increased from £307bn to £1,800bn in 2019-20, before the pandemic struck.
Of course, the author says, there are limits to how much debt can be serviced with comfort, but the UK is still a long way from these limits. UK public debt has been much higher in the past as a share of GDP.
The health of the public finances is also not as dependent on the Bank of England as some seem to think. The Bank’s purchases of government bonds have reduced the cost of borrowing, but the global economic slump and excess savings means that this cost would be low anyway. Interest is also still paid on the reserves created to buy the bonds. This is best seen as an asset swap which has shortened the maturity of public sector borrowing, rather than the printing of ‘free money’ to fund the deficit.
The crunch may therefore come sooner if interest rates were to rise sharply and exceed the growth rate of the economy by a large amount. But it is more likely that interest rates will remain relatively low and that a rebound in growth will help to stabilise the debt-to-GDP ratio at a sustainable level.
Recent better economic data and the rollout of the Pfizer-BioNTech Covid vaccine mean that the Office for Budget Responsibility’s “upside” scenario now looks increasingly accurate. In this case, GDP would be back to pre-Covid levels by end-2021, unemployment would peak only a little higher than it is now, public debt could be back down to 90.5 per cent of GDP in five years, and there would be “no need for any form of ‘austerity'”.
However, even if the government does not face the same financial constraints as a household, high public spending and borrowing has many other costs, including the misallocation of resources and the risk of runaway inflation (especially if it is paid for by money printing).
While it is misleading to claim that the UK has already ‘maxed out its credit card’, it would be even more misleading to suggest that the government has a ‘blank cheque’ to spend or borrow as much as it likes, whenever it likes, the author concludes. Public sector spending has already averaged around 40 per cent of GDP since World War II – “surely more than enough to fund good public services and a decent welfare safety net”.
It must be possible, Jessop writes, to find substantial savings by pulling back from activities that can be done at least as well by the private sector and still have room to increase public investment in the limited number of projects that cannot be left to the markets.
Julian Jessop, IEA Economics Fellow, independent economist and author of the paper, said:
“It is a serious mistake for supporters of fiscal responsibility to argue that the government is running out of money. Not only is this bad economics, but it also draws attention away from the real problems that can be caused by excessive public spending and state intervention.”
Notes to Editors
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Julian Jessop is available for further comment.
The mission of the Institute of Economic Affairs is to improve understanding of the fundamental institutions of a free society by analysing and expounding the role of markets in solving economic and social problems. The IEA is a registered educational charity and independent of all political parties.